Much of the product development work in the last year in the structured products market has been focused on index creation and the structuring of products linked to proprietary indices. As index-linked products continue to be introduced, we are receiving more inquiries from clients regarding back-testing of index performance.
A number of questions arise in connection with including historical data (whether hypothetical or actual) regarding index performance. The SEC has not directly addressed the issue of back-testing in connection with structured products, although one can intuit many issues that are likely to cause regulatory concern and perhaps even analogize to SEC Staff guidance provided in other areas.
The first and most obvious concern is to ensure that if back-testing information is presented, it is fairly presented. In other words, to the extent historical data is shown, the issuer should make sure that it is providing performance for a representative period, and not tailoring the presentation to show the most favorable performance results. Also, depending on the type of index, the period presented may not be long enough to evidence index performance during varying market phases. Second, the historical data should be accurately described—for example, is it data that is re-created for an index that was just recently introduced, or is it actual historical performance? Third, the issuer will want to accompany the performance information with explanatory disclosure that is balanced. The disclosure should note that the information is indicative performance data only. Moreover, the disclosure should note any special circumstances or factors that would limit the predictive value of the information. In other contexts in which the SEC has addressed performance results, the SEC has advised that results be accompanied by prominent disclaimers to the effect that past performance is not indicative or suggestive of future results. In the context of a structured product, any discussion of index performance should be balanced. It should be clear to any potential investor that the performance of the index is but one factor that the investor should consider in making its investment decision. The investor will also want to take into account all of the risks relating to the index as well as the payout structure of the offered product and the credit risk of the issuer (among other factors). Regulators have also expressed concerns regarding whether investors in structured products fully appreciate that most products are buy-and-hold products. Accordingly, the disclosure may also state that the data only provides a historic perspective on product performance if the instrument were held to maturity.
Some insight may be gleaned from the SEC Staff’s views on performance measures in other contexts, including fund products and variable annuity type products. For those products, the SEC cautioned that any performance based advertising should not be false or misleading and should not create unrealistic investor expectations. The SEC Staff noted that portrayals of past performance might be misleading if they omit appropriate explanations and qualifications regarding the information that is presented. Also, information might be misleading if additional detail is omitted in the case where historical performance is presented only as to particular periods. The Staff also required the inclusion of disclaimer language regarding past performance, as well as enhanced disclosure of risks, fees, expenses or other costs that might affect future returns or impact a potential investor’s investment decision. Finally, in this context, the Staff also focused on the prominence of certain disclosures and the proximity of the discussions relating to benefits compared to those disclosures relating to risks or other warnings. Given FINRA’s focus on fair and balanced language and on the prominence/proximity of certain types of disclosures, these considerations should be familiar to those drafting structured product disclosures.
In certain countries, regulators have objected to back-testing, while in others some measure of back-testing is required. Interestingly, the many regulatory reviews relating to retail structured products in Europe (including the Retail Distribution Review and the PRIPs consultation) do not address back-testing. We will be monitoring new guidance on back-testing.